The Federal Reserve (also known as the Fed) is, quite simply, the world’s most important financial instution. It is the central bank of the United States, which is the world’s largest and most important economy in the world. It governs the money supply of the US dollar, which is the world’s primary reserve currency.
The Federal Reserve uses monetary policy to stabilise the US economy. Here is how we can expect the Fed to react to various economic conditions:
- Overheating economy (inflation is too high) – the Fed will tighten monetary policy (raise interest rates and/or sell bonds on the balance sheet)
- Contracting economy (inflation is too low and/or unemployment too high) – the Fed will loosen monetary policy (lower interest rates or buy bonds)
Decisions on monetary policy are taken via a vote on the rate setting committee, the FOMC.
The Fed’s “Dual Mandate”
The Federal Reserve is mandated by law to provide stability to the US financial system. It should “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”.
This means the Fed needs to:
- Keep inflation low and stable – with an inflation target of 2% over time.
- Pursue the highest level of employment that the economy can sustain over time.
The Fed also promotes financial stability by supervising and regulating financial institutions, whilst also promoting consumer protection and community development.
The FOMC
The Fed ‘s decision making committee is known as the FOMC (Federal Open Markets Committee). The 17 member committee (7 board members plus 12 regional bank heads) decides on the level of interest rate (known as the Fed Funds rate) and the size of assets on its balance sheet (which can be adjusted by either buying or selling bonds).
The 7 board members cast a permanent vote on policy, along with 5 of the 12 regional heads. The regional voters are changed every year.
Why is the Federal Reserve important?
The Fed sets monetary policy for the US. This forms the basis of how US Treasury bonds are priced. US Treasuries are seen as the “risk free” asset and are considered to be a benchmark around which many financial instruments (such as loans, mortgages and corporate debt) are priced. This applies both in the US but also around the world.
The decisions of the Fed also directly impact the strength of the US dollar (USD). According to the latest data from the Bank of International Settlements, the USD accounts is one half of 88% of all foreign exchange transactions around the world. As at 2019, the global forex market was worth over $6.5 trillion per day.
Broad Impact
The FOMC meets every six weeks and it has the power to move markets. US bond yields; the USD; commodities such as gold, copper and oil; and Wall Street indices will all be impacted by the Fed’s decision.
N.B. Look out for hints of what the Fed might do at the coming meetings. The speeches FOMC members also have the power to move markets.
Trading the Fed
| Fed decision | Likely Market Reaction |
| Tighter than expected monetary policy | Treasury yields higher |
| USD strengthens | |
| Commodity prices fall | |
| US indices/equities fall | |
| Looser than expected monetary policy | Treasury yields fall |
| USD weakens | |
| Commodity prices increase | |
| US indices/equities increase | |
